False Dawn for the Aerospace and Defence Market

UK Aerospace & Defence shares have outperformed the market since the start of the current bull market rally in August 2011 (with the past 12 months seeing sustained outperformance by defence and underperformance by aerospace). We regard valuations as being broadly fair for aerospace names, given the cyclical backdrop. But we are concerned that defence stocks have priced in a bottomed-out budgetary environment that we believe is still far away, and as such, we believe that they may be vulnerable to de-rating.

Outlook remains of deep contrast: a tempered positive for Aerospace…

For Civil Aerospace, in the key Large Commercial segment, the Original Equipment (OE) cycle continues to be well-supported by extraordinarily high manufacturer backlogs, mid-single digit air traffic growth and the airline profit environment. OE deliveries are ramping up slowly (with the supply chain under stress) and they continue to reflect new industry record highs. The cycle for the higher-margin Aftermarket (AM) continues to show a dynamic of a slow (but gradually accelerating) recovery vs. prior cycles.

…and a negative for Defence

While gradual GDP growth recovery for major developed markets is starting to alleviate fiscal pressures on defence budgets, debt burdens and the lower priority for defence spending post-withdrawal from Afghanistan and Iraq (absent further major theatre operations) is likely to involve more cuts, in our view, to the trajectory for US defence spending and at best, flatness for major-country European spending. We believe that company guidance and consensus opinion is that the worst is past, but that this overlooks the disruption that year-on-year cuts and planning uncertainty may cause.

M&A is prompting some change, but it is minor

Companies have sought to acquire to expand civil aerospace, other industrial or cybersecurity end-market exposures and to sell (or quietly to close down) slower-growth activities within defence. The scale of portfolio change (and thus EPS outlook), however, has been mostly minor and no large-scale demergers have occurred in the UK.

Valuations look stretched for Defence, broadly fair for Aerospace

Since the start of the market’s recent bottom in August 2011, UK Aerospace stocks (on an unweighted basis) have risen by 86.7%, UK Defence stocks (unweighted) by 61.4% and the FTSE All Share by 38.9%. On a next-12-months (NTM) consensus P/E basis, UK Aerospace stocks have re-rated by 3.5x (unweighted), Defence stocks by 5.7x (unweighted) and the FTSE All Share by 4.3x. This leaves current NTM multiples at 13.5x for Aerospace, 14.1x for Defence and 13.9x for the FTSE All Share, which we view as broadly fair for Aerospace (given the relatively slow pace of the recovery and US dollar weakness), but as clearly stretched for Defence, given a very sluggish forecast EPS trajectory, likely difficult newsflow and US dollar weakness.

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